Covered Call Options: The Gift that Keeps on Giving
The covered call is a tactic in which an investor writes (sells) a call option contract while simultaneously owning an equivalent number of shares of the underlying stock. It is most often employed when the investor, while optimistic on the underlying stock, feels that its market value will experience little range over the lifetime of the call contract.
The investor wants to generate additional income from shares of the underlying stock and/or provide a limited amount of protection against a decline in underlying stock value.
Advantages of Selling Covered Calls
Disadvantages of Selling Covered Calls
Let’s create an example using Caterpillar (CAT) by going long 100 shares of CAT @ 47 @ and short 1 January CAT 55 Call @ 4.25. The maximum profit is the premium received for the short call option plus the profit to be gained on the long stock. The maximum reward on the option side is $425 (4.25 x 100 = $425). The maximum reward on the stock side of this position is $800 [(55 - 47 @) x 100 = $800]. The total profit on this particular covered call strategy is $1,225 (425 + 800 = $1,225). The maximum risk is limited to the downside as Caterpillar drops in price beyond the breakeven all the way to zero. The breakeven on a covered call is calculated by subtracting the call option premium from the price of the underlying stock at initiation. In this example, the breakeven is 42.75 (47 @ – 4.25 = 42.75). Caterpillar must drop below 42.75 for the trade to begin to take a loss (not including commissions). The maximum profit will be received if the stock rises to or above 55 and the call is exercised. On December 24, Caterpillar climbs above $55 per share. If the short 55 call is exercised, 100 shares of Caterpillar will be sold to permit delivery to the assigned option holder. The $425 credit from the option and the additional profit from the sale of the Caterpillar shares bring the total profit on the trade to $1,225.
This strategy generates income because the investor keeps the premium received from writing the call. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.